At a glance:
- In our view, now is the right time for firms to consider how climate-related risks can affect their customers, particularly as foreseeable harm and poor customer outcomes resulting from climate-related risks may lead to breaches of the UK Consumer Duty (the Duty).
- UK insurers should define and identify key climate-related risks that are likely to affect their customer base and assess their materiality, especially for those customers in scope of the Duty. Material exposures should then be proactively managed.
- Firms should start with assessing the impact on consumers. In particular, where firms make use of exclusions to manage climate risks, they should test that these do not result in unfair outcomes for customers.
- Firms should also map out the impact of each consumer climate risk they identify on the delivery of good customer outcomes across the four outcomes of the Duty.
Relevant to: Board members and senior executives working across the UK insurance sector, in particular those in risk and compliance functions, regulatory affairs, as well as product design and marketing teams.
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Over the past few years, regulators have increased expectations of financial services firms to improve their management of climate risks. This includes expecting firms to assess the materiality of financial risks, develop scenarios and stress testing, consider management actions engage in sustainability disclosures, and determine ongoing capital adequacy in the context of climate risk (see our previous blog for more detail).
We have also seen an increase in regulatory standards and expectations around conduct risk. The FCA expects firms across financial services to deliver good outcomes for their customers and avoid foreseeable harm. These higher standards are reflected in the rules and guidance under the Duty, which will be implemented by the end of July 2023 for the majority of financial services products in the UK.
As climate change begins to create real challenges for financial services consumers, the climate and conduct nexus is therefore increasingly important. The FCA has, for example, proposed to introduce an “anti-greenwashing” rule, while also pointing out the various Duty considerations for green mortgages. From 31 July 2023, insurers should therefore assess the extent to which their products will leave policyholders exposed to harm from climate risks and take action where this is the case.
In this blog, we identify what we think are some practical steps that firms can take to ensure they consider the climate-conduct regulatory nexus. As part of this, we have developed a framework that firms can start using to help them assess their approach to consumer climate risk.
The climate‑conduct regulatory nexus: how are climate risks and conduct rules connected?
Climate risks and conduct rules are connected in the sense that any significant risk that may lead to a financial services product failing to deliver good outcomes for customers, and where this failure could have been foreseeable, is likely to result in a breach of the Duty. And, in our view, there are many ways the risks related to climate change can affect firms’ delivery of good customer outcomes, which we go into in more detail in the next section.
Below is an illustration of how we see the climate-conduct nexus. Importantly, the Duty is built around four outcomes: Price, Value, Consumer understanding and Support (the outer circle). There are two main types of climate risks that are central to consumer exposures: transition and physical risks (the inner circle). Firms should assess the impact of these two types of climate risks against the four outcomes of the Duty. This should then inform the firm’s approach to managing its customers’ exposures to climate risk.
A. The climate-conduct nexus explained
Consumer climate risks
Physical and transition risks are the climate-related financial risks that are most likely to result in poor customer outcomes if unaddressed.
Physical risks: These relate to the risks associated with an increase in the frequency or severity of weather events such as flooding, storms, droughts, heat and cold waves, and forest fires. Recent research suggests that the frequency of climatic natural disasters has grown as much as threefold since 1980 (our estimation based on data from the Emergency Event Database of the Centre for Research on the Epidemiology of Disasters).
According to the PRA, these events “bring physical risks that impact our society directly and have the potential to affect the economy. If these events happen more frequently, people will become more reliant on insurance to cover the costs of damage to their houses and cars.”
Physical risks can affect consumers in four main ways:
- directly, by increasing the likelihood of damage to life and property, and therefore increasing the importance of products that meet customer needs and clear communication of exclusions and limits so customers can make informed decisions;
- indirectly through the value of insurance investments for which policyholders bear the investment risk. For example, if the value of certain assets is severely eroded by physical risks such as floods and other weather events, this will reduce the value of policyholders’ portfolios in life and pensions products;
- as physical risk leads to more severe and frequent catastrophes, certain risks might become “uninsurable”, leading insurers to withdraw coverage, widening the insurance protection gap and leaving customers without financial protection; and
- lastly, insurers could also feel an impact on their operational ability to process claims and provide effective customer services against a backdrop of increasing and more complex consumer climate risks.
Transition risks: The PRA describes transition risks as those “occurring when moving towards a less polluting, greener economy. Such transitions could mean that some sectors of the economy face big shifts in asset values or higher costs of doing business.”
Transition risks may develop in relation to certain general insurance products. For example, home or motor insurance products where the home or vehicle might over time fail to meet the required emission thresholds or energy efficiency standards, which might in turn result in withdrawal of coverage or price rises.
Transition risks can also affect consumers where the value of policyholders’ investment portfolios is sensitive to the transition to a lower carbon economy. The value of investments in sectors such as oil, coal, gas, construction, aviation and transport could fall significantly, leading to the possibility of stranded assets and, as a result, material losses for policyholders in the life and pensions sector.
Managing consumer climate risk
We have designed a framework to manage consumer climate risks, which is underpinned by two key principles.
B. Two key principles
C. Overview of framework to review consumer climate risks
1: Define: Firms need to define consumer climate risk in the context of their business model, including their products, target markets and geographies. Insurers and intermediaries may wish to map their products and services to where their customers are the most likely to be exposed to climate-related risks (see illustration A).
2: Assess: Firms should assess the materiality of their customers’ exposure to physical and transition risks in a systematic way. For example, insurers may identify that their customers could potentially be affected by physical climate risks in several ways, but within that, they need to perform a materiality assessment of those aspects of physical climate risks that are the most material to them.
3: Measure: Where insurers have deemed certain climate risks material to themselves, it would be reasonable for the FCA to expect firms also to assess to what extent policyholders are exposed to these risks. For example, if an insurer concludes that investment in certain carbon intensive industries poses a high risk to its own balance sheet, it should reach the same conclusion when the investment risk is borne by its policyholders. Consequently, this risk should be clearly signposted to policyholders and considered as a source of potential foreseeable harm.
Measuring climate consumer exposures can be done through scenario analysis and stress testing. On the underwriting side, in particular, insurers are already likely to have a good understanding of their customers’ physical risk exposures (including in residential home and property lines) and should be able to identify groups of customers that might be underinsured and therefore more likely to suffer harm.
4: Manage: Insurers could choose to manage their own climate risk by changing policy wordings to narrow down coverage, lower limits or increase excesses. However, such measures transfer the risk from the insurer to policyholders and could therefore potentially lead to poor outcomes for customers. Therefore, firms must satisfy themselves that this type of risk transfer to policyholders does not result in unfair outcomes They should also make sure it is subject to the right level of scrutiny, challenge and governance from a conduct perspective. Firms may also choose to manage exposures by raising awareness and incentivising climate positive behaviours amongst policyholders, offering premiums discounts where this is observed.
5: Testing: Finally, testing customer outcomes should form part of the core process for dealing with consumer climate risk. Examples include testing product design against increasing climate-related risks and testing consumer understanding of key communications related to the green credentials of a product, the exposures of their investments to climate-related risks or features such as exclusions.
Reflecting consumer climate risks in the four outcomes of the Duty
The approach to managing consumer climate risks should be informed by the regulatory rules and expectations that firms must act to deliver good customer outcomes. The Duty applies to products and services offered to “retail customers” (FCA FG 22/5: Final non-Handbook Guidance for firms on Consumer Duty para 2.3 and 2.32). In the insurance sector this means most policyholders except those in relation to large commercial risks, risks outside of the UK and group insurance policies.
The table below provides some examples of questions insurers may want to ask themselves when considering the climate-conduct nexus in the context of the Duty.
D. Mapping consumer climate risks against the four customer outcomes
Outcome 1: Products and services
Outcome 2: Price and value
Is the product designed to cover an adequate level of climate-related risk?
Are the pricing models likely to create access issues as more information is gathered on climate risks and target markets?
Are vulnerable customers disproportionately affected?
Have issues around access to insurance and financial exclusion been considered, including in cases of re-pricing to reflect climate risks?
Do any changes to policy wordings, limits or exclusions reduce the value of the insurance product to unacceptable levels? What is the impact on specific cohorts of customers?
How is risk of stranded assets managed?
What is the probability of harm in green funds?
Do target markets need updating for green funds? Is a negative target market necessary?
What is the impact of more stringent energy efficiency standards on the home insurance portfolio? Could it lead to a new group of potentially vulnerable customers over time? How to consider this aspect in target market definition?
How does the firm carry out Value Assessments for green funds relative to non-green funds?
How is the strength of a customer’s preferences and risk trade-offs measured?
How can changes to regulations (energy efficiency or emission related) affect the value of homes and vehicles and, as a consequence, insurance products?
Outcome 3: Consumer understanding
Outcome 4: Consumer support
How does the firm communicate changes to policy wordings, exclusions, excess and coverage limits, and test customers’ understanding of these?
Is the firm providing timely communications to allow customers to make informed decisions?
Has the firm identified whether more disclosures around climate-related risks should be included in communications?
What is the firm’s capacity to respond to a large volume of claims in a timely manner to maintain the expected level of service?
Has foreseeable harm and impact on value of delays in claim payments been considered? And has the need for appropriate support in the event of a large severe climate-driven peril been factored in?
How does the firm provide proactive support for those customers identified as underinsured or at risk of harm?
Has the firm tested whether customers understand transition risks?
How should the firm communicate greater uncertainty around the value of asset classes with incomplete climate-related data?
How can biases be avoided when presenting complex climate-related information to customers?
Do customers have access to appropriate and timely support to make decisions about green relative to non-green funds?
Do customers have support to understand how the energy efficiency or emission levels of their property or vehicles affect the performance of insurance products, including price and value considerations?
UK climate and conduct regulations are closely linked as consumers are increasingly, and significantly, affected by climate change in various ways. Inevitably, consumer climate risks will eventually have to be considered by firms to comply fully with the Duty.
Insurers should therefore start assessing how key climate-related risks are likely to compromise consumer outcomes and determine the safeguards they need to put in place to prevent harm.